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DEMYSTIFYING VAT Series 1 – VAT Basics
Kreston Menon
By now most of you must be aware that the government will be implementing VAT in UAE (value added tax) from Jan-2018. The rate of VAT would be about 5%. Amongst the GCC member countries, UAE is not alone to go ahead with implementation of VAT.Other GCC members have also agreed to implement the VAT around the same time as UAE. I plan to share with our readers through our quarterly newsletter about various aspects of VAT rollout in the UAE as it unfolds.
In this Series, I begin with basic outline of VAT and in subsequent issues will be covering the regulatory and procedural aspects of VAT, similarities and differences between the VAT that is implemented in EU versus what is being unfolded in the GCC and the UAE, impact of VAT on certain categories of business, notably the gold business in the UAE and lastly a VAT primer which will help our clients to transition to VAT regime with ease.
VAT in simple terms is:
A tax that applies, in principle, to all commercial activities involving the production and distribution of goods and the provision of services
A consumption tax because it is borne ultimately by the final consumer
Charged as a percentage of price (in UAE it will be 5%), which means that the actual tax burden is visible at each stage in the production and distribution chain
Collected fractionally, via a system of partial payments whereby taxable persons ( VAT-registered businesses) deduct from the VAT they have collected the amount of tax they have paid to other taxable persons on purchases for their business activities. This mechanism ensures that the tax is neutral regardless of how many transactions are involved
Paid to the revenue collection agency of the government by the seller of the goods, who is the “taxable person”, but it is actually paid by the buyer to the seller as part of the price. It is thus an indirect tax
As of now, the GCC countries such as Saudi Arabia, UAE, Qatar, Oman and Bahrain do not have VAT or sales tax as part of their indirect tax kitty. The indirect taxes currently levied by these countries include customs duty (GCC), excise duty (GCC) and in some cases tourist/ hotel tax and few other indirect taxes. In the UAE only customs duty is levied on CIF value of import of goods which varies based on the nature of goods imported and averages to about 5%. One of the key reason for the GCC countries to implement VAT is to converge with the international tax regime on indirect taxes and be in line with the suggestions of the IMF.
The other key motivations for the GCC countries to implement VAT is to help improve revenue side of the respective countries’ budget, provide cushion against volatile hydrocarbon pricing and as a consequence bring stability to non-oil revenue. For the UAE government the revenue from VAT is expected to about AED10 billion to AED12 billion in 2018, according to the Ministry of Finance. The introduction of VAT can also be expected to improve the ratio of non-oil to oil revenue from the present ratio of 1:2.
The history of VAT began in Europe in the 50’s. VAT was first adopted by France in 1954. By the 1990’s VAT had been adopted throughout the European Union and in many countries in Africa, Asia, and South America. At present, over 150 countries have included VAT as part of their indirect tax collection. About 70 countries in Africa and Asia have implemented VAT. However, one may note that two notable exceptions are the USA and Canada which have not implemented VAT. VAT as stated earlier is a consumption tax, as it is a tax on commodities purchased, ultimately for consumption, rather than on the income of an individual or corporate entity.
The idea behind the VAT is that each step in the production chain pays a tax on how much value it added to the product. It is a levy on the amount a business adds to the price of goods during the stages of production and distribution. The tax is levied on the value added to the product at each stage of its manufacturing cycle as well as the price paid by the final consumer. Commonly, the seller at each stage subtracts the sum of taxes paid on items purchased from the sum of taxes collected on items sold; the net tax liability due to VAT is the difference between tax collected and tax paid.
VAT is collected by the tax credit method; each firm applies the tax rate to its taxable sales, but is given a credit for VAT paid on its purchases of goods and services for business use, including the tax paid on purchases of capital equipment under a consumption-type VAT. As a result, the only tax for which no credit would be allowed would be that collected on sales made to you and me as individuals, rather than to business.
Let me illustrate the mechanism of VAT with a simplified transaction involving production, processing and sale of Dates to end consumer. I have chosen VAT rate of 10% (UAE VAT would be 5%)
Many economists believe that VAT is a regressive tax and impacts the lower income people harshly. Countries that have implemented VAT have learnt from their experience and have come up with improvements that lighten the burden on lower income people. As a consequence in many countries, necessities are often taxed at a lower rate than luxury items. Advocates of the VAT contend that it is an efficient method of raising revenue. In the UAE the proposed VAT rate of 5% from 2018 would exempt education, healthcare and about 94 common consumption food items.
I believe that the competitiveness of the UAE as preferred destination for global business entities would not be affected by the implementation of VAT. However, in the case of few businesses such as gold trade in the UAE, there may be a marginal impact on trade volumes though this may need further analysis. I shall be covering such select aspects subsequently in my series of writings on “Demystifying VAT.”
This article was originally published in Kreston Menon April- June 2016 Newsletter.
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Capital Raising – A Key Challenge for Business
Kreston Menon
For any typical business, access to appropriate funding is a major challenge. Many businesses struggle due to cash flow, lack of access to working capital, or probably due to wrong funding solution not suited to the nature or cash flow profile of the business. Many businesses struggle to grow beyond a threshold due to sub-optimal funding strategy.
Global financial uncertainty continues to cause anxiety amongst issuers and providers of capital. Corporates fear that future funding needs may not be met, while providers of finance worry about their capital positions and are not confident about funding corporates in fast changing business environment.
We have seen recently in UAE number of trading business houses “running away” leaving behind significant amount of bad loans for the banks. Bankers, Financial Institutions and Investors are becoming more and more cautious thereby choking flow of funds to even genuine business houses. Broadly speaking, capital needs for a typical business can be categorised into Debt and Equity Capital with each of them having their merits and demerits. I will outline a few guidelines that can help to prepare your business for efficient capital raising (Debt / Equity) and tapping diversified pool of liquidity:
A.Think BIG -> Plan your funding roadmap: Relying purely on Private Sources for capital needs limits the business growth. Many successful large business houses could not have grown to their present size without being able to raise capital through multiple and large liquidity pockets i.e. Financial Institutions (Banks / NBFCs) and further through Capital Markets (Debt and/or Equity)
FUNDING ROADMAP to fuel your Business Growth
B. Clearly Define your Funding Strategy: While developing and defining a Funding Strategy for a business, Management must deliberate on following major factors:
What is the most appropriate Capital Structure for the business?
What is the optimum level of leveraging / gearing for the business?
Rely purely on debt solution or expand through diluting equity stake?
What sort of debt instrument or combination of debt instruments is best suited for the business?
How much of working capital is required?
CAPEX Funding v/s Working Capital Funding
Cash flow Management – debt profile or maturity is in sync with operating cash flow generation of the business?
C. Identifying right level of debt for the business : Both Under leveraged Balance sheet and Over Leveraged Balance sheet are not considered good for the business
The degree to which a business is utilizing borrowed money is defined as Financial Leverage. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Financial leverage is not always bad, however; it can increase the shareholders’ return on investment and often there is tax advantages associated with borrowing. Generally business owners with very low risk mind-set ends up in an underleveraged business. A Behavioural argument suggests that a business may also become inefficient due to under leveraging, as the lenders may also help and create appropriate checks and balance for the business and bring financial discipline which is very important for the continued growth of the business.
D. Identification of Right Funding Solution / Instruments
Many businesses fail due to implementation of poor funding strategy / solution. For e.g. an Infrastructure project with a payback profile of say 10 years should not ideally be funded with a Term loan with three years of maturity. Cash flow profile of the business should be matched with the debt maturity profile. We have seen number of countries / businesses getting into financial crisis due to wrong funding solution. Also, optimum cost of funding can be achieved by applying the right funding solution. For e.g. an equipment purchase may be cost efficient if financed through lease financing compared to business loan. Similarly procurement of a Capital Asset with ECA backed financing can be more cost efficient compared to normal business term loan.
E. Continuous Planning and Financial Discipline:
Ability to raise capital (debt or Equity) to fuel business growth is a virtue. This requires years of planning and financial discipline. It cannot be an overnight solution. Careful planning and preparation is critical for successful capital raising initiative. Companies have to plan well in advance and put in place dedicated resources and advisors to work in focused manner. This includes but not limited to following key considerations and preparations:
Implementation of Corporate Governance Mechanism
Documentation of policies and procedures
Transparency – Keeping Investors / Potential Investors Informed
Audited Financial Statements
Clean Audit Reports; Working with right set of Auditors and Advisors
Clean Financial History of the company as well as promoters; Management Profiles
Banking Relationships
Management Accounts and reports
Public Profiling of the company
Risk Management framework, Internal Controls
Market Timing: Keep yourself ready and approach the market when the market is right for you
F.Clear demonstration of the usage of the Capital :
When a company issues new Debt or Equity, the borrower/ Issuer should be able to clearly articulate the specific purpose of the required new capital. The most common purposes of new debt include the following:
To Fund CAPEX;
To Fund OPEX / Working Capital;
To Fund Growth / Expansion;
To Acquire New Asset;
To REFINANCE existing loan with a relatively cost efficient loan;
To REFINANCE existing Debt with a better structured debt more suited to the cash flow profile or capital structure;
Be Transparent and Truthful: The financial markets are becoming more and more intelligent to see through any “Smart Accounting” or “Window Dressing”
Audited financial statements are subject to series of judgement. Bankers, Investors or Analysts rely on Audited Books of Account, along with other due diligence which they generally perform. For those reason – bankers, financial institutions and Analysts are more and more willing to accept reports from reputed Audit Firms and Advisors only.
Bubble, crisis, contraction and recovery are stages of the business cycle that keep repeating. Capital flow is closely linked to economic cycle. In stricter market conditions, a robust business model, strong balance sheet, readiness to embrace greater investor scrutiny and accepting higher financing costs might be required. You can certainly achieve your objective with thorough planning and careful execution. Better get this right the first time, it becomes more difficult after one failed attempt. “Timing is Key” – Pitch it carefully. Keep your financial history clean and make it a competitive process by networking with right set of bankers, financial institutions, and investors.
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Startup Challenge: Importance of MVP
Kreston Menon
Minimum Viable Product (MVP) helps a startup team begin to learn the process of learning as quickly as possible. MVP should not be confused with the smallest imaginable product. MVP allows you to test an idea by exposing an early version of your product to the target users and customers,to collect the relevant data, and to learn from it. Contrary to traditional product development, which involves throwing tons of money on building a product to perfection, the goal of MVP is to come up with the ultimate product. MVP unlike a pilot project is designed not to just test the product design or feature but to test the fundamental business postulate.
Eric Ries in his book ‘The Lean Startup’ came up with the BuildMeasure-Learn feedback loop. The core of the startup models can be fitted into this Lean Startup model outlined by Eric Ries. In startups, an idea is turned into a product. As customers use the product, the feedback and data generated becomes useful learning for the product developer to further refine the product in the least possible time.
Startup face immense challenge in identifying features that are not essential when rolling out the MVP considering that the goal is to come with version of the product that enables a full turn of the Build- Measure-Learn loop with minimum effort and least amount of development time. The product development team should be able to ensure that customers do not face any issues when using the minimum features of the product.Simply stated,the product may not necessarily have all the features in the first release but the features provided should work without any issues and be able to achieve the intended usage of the customer. The product team should not fall into the trap of rolling out their best product idea or best designed product. The focus of the product team should be to launch the first version of the product without any bugs in the least possible time, get feedback of the users and incorporate the key learnings into the product in the subsequent release. The product team should realize that the MVP launched for customers may deliberately lack many advanced features that may be useful at a later stage, for an expert user of the product.
Startups need to realize that despite the merits of MVP, there is certain amount of risk in adopting the MVP strategy. The risk is especially from those customers who use the product after paying and find that it does not meet even their basic requirements or it has bugs that are irritating for them to use the product. In such cases the users may not return to buy the subsequent release of the productor even may not use the product even when the subsequent version of the product is given free.
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The concept of MVP can be sacrilege for many entrepreneurs and quality professionals who believe in perfection of end product when rolled out to customers. Their expectation about their product is very high, state-of-the art and that catches attention of the users. They will spend huge effort and resource in developing a product which would meet their expectation but may struggle to get customer validation. Such a scenario is a sure disaster for a startup that plans to launch a successful product. To quote Eric Ries: “If we do not know who the customer is, we do not know what quality is.” Many early stage startups in the beginning of 2000 startup boom suffered because of the entrepreneurs trying to come with a perfect product spending huge effort and time without trying to get early customer feedback and validation, thereby becoming financially unviable.
There is no readymade formula that can help to decide essential features for a MVP. Deciding how complex a MVP should be requires judgment which many a times, the startup entrepreneurs may lack. The best way to arrive at MVP is to simplify as much as possible and have only those features that are essential to validate initial assumptions and that can be quickly built into the product.
How many features the product should have to appeal to early adopters is a tough but critical question which will need a good understanding of the domain for which the product will cater. Every extra feature that is provided in the product which is not useful for early user of the product is a wasted effort which would inflate the product development cost. The important lesson of MVP is that any additional work of the product development to add features beyond what is required to learn customer requirements is a waste, no matter how important it may seem to the product development team.
Also Read : DIGITAL MARKETING FOR BETTER DEMAND GENERATION
The focus of the product development team needs to be creating the MVP that helps them to test and get answers about few assumptions of theirs from their target customer. Eric Ries illustrates the example of Zappos, the biggest online retailer on how they went with a small scale experiment to validate their assumption about target customers. The founder of Zappos, Nick Swinmurn felt that there was no online store where one could get great selection of shoes. He began his experiment not by creating huge inventory of shoes and investing in an e-commerce backend. Instead, he went to local shoe shops asked shop owner’s permission to take photos of shoes and put them online. Once the orders were received from retail customers, he went to the shop, bought the pair that was ordered, shipped it, handled payments, returns… all of it himself. Obviously it was not a scalable business model, but it was an experiment designed to answer one question: is there already sufficient demand for a superior online shopping experience for shoes? Nick was able to validate most of his assumptions with a very little investment in shortest possible time.
For startups that need to be successful and grow, the MVP model can be very effective to avoid getting into the trap of being satisfied with limited set of customers. MVP model allows startups to bring out successive versions of the product at minimum development cost and release product in minimum time. If one studies the pattern followed by successful product companies, many of them admit that their initial mistake was to develop the product with too many features. Successful ones soon realized that they can’t be everything to everybody. Startups should not confuse less-features product with lowquality product. When MVPs are perceived as low-quality product by customers it becomes an opportunity for startup to learn about attributes that customers care about. Such an approach to product development would be much better than merely speculating about customer needs and will provide a solid basis to build future products that are successful in the real world.
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Catch-22 for Brick & Mortar Retailer’s – e-retail or not ?
Kreston Menon
In India, e-tailers like Amazon, Flipkart and Snapdeal in recent years have not only made the youngsters below 30 their ardent buyer from their online platform but also have of late been able to net the people in the age group of 30 to 50 as their customers.In the case of below 30 customers, the e-tailers lure them through latest imported offerings under fashion accessories and electronics which the brick & mortar players do not provide with so many optionsFor above 30 customers the value proposition that the e-tailers bring in is not only limited to convenience of buying but also the price discounts compared to physical stores. More and more niche e-tailers entering the consumer segment coupled with increasing penetration of cheaper internet services penetrating to new areas is further giving fillip to the e-retail business gaining more traction from the masses leading to share of online purchase increasing at the cost of physical stores.
Why the Brick & Mortar Players adopted an “Ostrich like attitude” to the e-tailers when the war began between them and e-tailers? Did they really believe that the buying habits of people are hard to change? Did they believe that people used to buying from physical stores would not buckle to the emerging trend purchasing online?Did they believe that the e-tailers do not have a robust business model that can last long? Did they believe more highly about their physical stores model compared to shopping online model? Was it the legacy management style of the Brick& Mortar Players refusing to foresee the technological revolution happening propelled by internet?
In my opinion there is a combination of above factors besides others that led to growth of e-tailers and physical retailers slowly losing market share to e-tailers.
The most notable change that has led to growth in market share of e-tailers is the fast changing technology in the hardware, software and data connectivity options that become widely available and the price of the mobile and data services falling drastically in the last five years. A new breed tech-savvy young entrepreneur began to create software and online marketplace with easy interface between small and medium retailers and buyers in the market place making online transactions a child’s play. The secured payment gateways offered by banks and credit card companies with additional security options by sending PIN for each transaction has also increased the customers confidence to shop online.
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The management of big physical retailers in many cases were often myopic, not to notice the software and communication revolution happening and impact on their sector. If only the top bosses at retail companies had realised that the first victim of the technological and communication revolution were the traditional banking and insurance sector and next would be retail, they could have better prepared themselves to face the onslaught of the e-tailers.
The information technology and internet totally changed the way banking is done today compared to the late 90’s and the early 2000. In the late 90’s it was the India-based new private banks such as HDFC and ICICI besides Citi and HSBC which started the ATMs, online banking in a big way when the traditional government banks scoffed at them.
The traditional banks also patted themselves when online frauds happened at the nascent stages of the e-banking. During the initial years a majority of the customers of the banks also initially were reluctant to deal with their banks through online platform, fearing online fraud. As technological advances made online banking safe, more customers began to bank online and today online banking has sizable share in terms of number of transactions and in terms of value it has surpassed traditional banking at counters.
Banks that avoided automation have now aggressively migrated to online platforms and in many cases such as State-owned State Bank of India has even outgrown the private players in terms of automation and online offering of features and service for its customers.
The management of many Brick & Mortar retailers with more than two to three decades of experience initially ignored the e-tailers and looked at e-tailers with contempt as many of the e-tailers had their CXO’s in early 20’s. The physical retailers had full faith in their ability to brainwash their customer base through print and electronic media about perceived failings of the e-tailers and celebrated the failures of the e-tailers as their success. They totally underestimated the capability and capacity of the e-tailers to bounce back after each failure with greater success and more offerings for the online shoppers.
In many cases the Brick & Mortar stores created failure stories about online players offering inferior product through their platform or lack of after sales support, though the physical stores themselves were never good in providing after sales support. Rather the online players like Amazon and Flipkart with their free 30 days return policy where offering the customers something that the physical stores had never offered to customers in many Asian markets including India for decades
Today the online players are gaining more customers at the expense of physical stores. The primary reasons are the cheaper price of buying same/ similar product compared to physical stores, getting same or net day delivery at home, ability to see the product with three-dimensional view, multiple payment options like debit card, credit card and cash on delivery, wide choice of goods to compare and in some cases like mobile phones exclusive launches of new phones only through online platform.In families where both spouse work, due to high commute time to place of work, shopping online has become a convenient option. With more and more e-tailers offering goods online, almost everything which was exclusively available at physical stores can be now bought via mobile handset.
Also Read : Digital Marketing For Better Demand Generation
For most Brick &Mortar retailers, the shift in the retail ecosystem has negatively impacted revenues. Show-rooming has become a reality— the shopper uses the information provided by the staff at the store but eventually makes the purchase online, sometimes even while he/she is in the premises of the store. Many physical retailers are beginning to understand the power of e-platform and pervasive use of mobile technology by people of all age group which is leading to people experimenting with online purchase and many finally converting to online shopping as their primary mode for many categories such as books, shoes, mobile phones, consumer electronics, gifts, fashion accessories and apparel.
Having made huge investment in real estate by leasing or building physical retail stores the Brick & Mortar players are in a real dilemma. They cannot totally junk their business model and put their business and that of their lenders at risk. At the same time ignoring the e-tailers and not adopting a hybrid model whereby they have their own online shopping platform for their customers is a proposition they can no longer ignore. By having both physical stores and online platform they would end up competing against their own online format of stores, besides competing with other e-tailers. A very complex scenario of business model, where their online formats of stores would have to set a pricing for product that is lower than physical stores to match their competitors online. Such an approach would require them to revisit their physical stores business model and growth strategy and would definitely require junking some of their existing business plan and more importantly their earlier mind-set about online retail format.
The Brick & Mortar players also need to play to their strength when adopting a hybrid model of physical and online retail formats. In case certain category of purchases (e.g. home appliances and white goods and groceries) the shoppers like to touch and feel the product before they commit purchase online. In such scenarios the physical retailers can definitely have more loyalty from their customers by offering them touch and feel option besides attractive pricing.
e-retail is here to stay and Brick & Mortar players can no longer pretend to ignore the e-tailers. They need to revisit their business model that is built on physical stores expansion and identify product categories where they need to offer online platform for customers to shop. They may also need to take the hard decisions of closing many of their physical stores or stop certain products from being offered at physical stores. Brick & Mortar retailers will have to bring in below 30 tech savvy entrepreneurs into their management to successfully leverage the fast changing technology in the online retail space.
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VAT DESIGN AND ROLLOUT – Series 2
Kreston Menon
If we look at the international experience in VAT implementation, the VAT is paid on a net basis on the difference between sales and purchases (of inputs) and there should be no break in the VAT chain (through exemptions) to avoid tax cascading. Another notable feature of VAT implementation is the ‘destination principle’ which means that goods and services are taxed for VAT only in the jurisdiction where they are consumed.
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Converging Organization’s Governance,Risk & Compliances
Kreston Menon
The common problem which organizations are facing globally, while implementing robust GRC standards, is of Risk Silos. Risk Silos arises when each of the oversight function (individually) gathers information from business divisions to identify potential risks. This leads to duplication of efforts (Risk Silos) among various oversight functions (including Risk Management especially Operational Risk, Compliance, Corporate Governance and Internal Audit) which increases inefficiency within the organization. It also leads to disinclination of business managers to engage with oversight functions more proactively.
This article intend to discuss and deliberate the strategy for bringing synergy to the work flow and process of organization’s oversight functions (three lines of defense) to maximize the coverage of risk within the organization.
Current State Vs Future State
Organization must look to assess their existing GRC infrastructure and framework so as to identify the key challenges and address the same through implementation of sound convergence framework, thereby achieving the “Future State”
Risk Register – Integrated Assessment Process
In order to effectively manage the key risk areas of the organization, a common repository of risk is desirable. The same can be achieved with the implementation of a Common Risk Register among the various oversight functions of the organization
A Risk Register is a risk management tool which acts as a central repository for all the risk identified under the risk universe of the organization. Risk Register covers the rating of likelihood and impact for each key risk and their subsequent action plans.
Implementing a Risk Register would enable the organization to remove Risk Silos as it acts like a common platform for the communication of the key risk areas to the key stakeholders (including the various oversight functions discussed above) within the organization. Risk Register also facilitates the development of common risk language and methodology for assessment of identified risks among the various oversight functions, thereby reducing the duplication of efforts at assessment level. Finally, a common approach to mitigate the risk would enable the organization to strengthen its preventive/ contingency/ recovery actions.
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Convergence Framework
Organizations can develop a sound convergence framework that shall act as the guiding principle for the oversight functions to avoid duplication of efforts. The guiding principles should ensure that the roles and responsibilities of the oversight functions are not curtailed and that the independence of internal audit always remains. The framework shall also entail all the areas, where the overlap is prevalent, including, but not limited to:
- Identification Process for Risk Issues (RCSA/Audit);
- Control Based Rating vis-à-vis Management Awareness Based Rating methodology – to ensure the assurance approach is consistent;
- Common rating methodology
- Reporting of the issues to Board Committees & Stakeholders;
- Integrated Assurance Approach – Risk Register;
- Follow up on open risk/audit issues;
- Closing of the issues; and
- Review calendar of oversight functions and align visits to divisions.
The Convergence Framework should also entail the frequency of the meetings for these oversight functions to discuss and achieve Convergence of GRC. The same can be recommended based on the size and complexity of the organization.
Also Read : Startup Challenge: Importance of MVP
To conclude, Alignment & Convergence of the Organization’s GRC functions and processes can help reduce duplication of efforts and help provide increased confidence in, and transparency of, information but without compromising the independence required in the audit function, thereby minimizing Risk Silos and facilitating the sharing of risk information across the organization.
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